Key Takeaways

  • S corps provide broader liability protection to all shareholders, while only limited partners in a partnership enjoy similar protections.
  • Ownership restrictions apply to S corps—only U.S. citizens or residents may be shareholders, and the number of shareholders is capped at 100.
  • Partnerships offer greater flexibility in profit-sharing and capital contribution structures than S corps.
  • S corps may offer payroll tax savings by allowing owners to take salaries plus distributions, while partners in partnerships pay self-employment tax on all income.
  • Formation and compliance for S corps involve more formalities than partnerships, including election filings and annual reporting.
  • Qualified Business Income (QBI) deduction rules differ between the two and can impact tax savings.
  • Investors may find S corps less attractive due to ownership limitations and a single class of stock.
  • Partnerships are easier to manage informally, making them appealing for closely held businesses.

The difference between partnership and S Corps (or S corporations) is the limited-liability protection for owners of businesses taxed as S-corps. Such liability protection is not available for owners of general partnerships and can only be claimed by some partners in a limited partnership. The S-corp arrangement also makes business growth easier by enabling the issuance of stock to new shareholders, which is hard in partnerships. However, partnerships benefit from relatively lenient taxation requirements and absence of stringent registration and maintenance requirements.

Partnerships and S-Corps

Both S-corp and partnership business concepts were designed for small and medium-sized businesses. Both business types do not pay corporate tax and therefore, owners are shielded from the double taxation of C corporations. However, the two business types are very different in structure, taxation, and liability treatment of the owners. 

The enabling laws for partnerships are created by states. Therefore, partnerships are regulated by the states in which they are formed. Conversely, the S corporation arrangement was created by the federal government. The S corporation is not an entity type, but rather a form of tax treatment that is available to some corporations. The key differences between partnerships and S-corps are discussed below.

Ownership

  • Ownership Laws
    In an S corporation, ownership is limited to U.S. citizens or residents. These limitations do not apply in a partnership. S corporations cannot have more than one class of stock; therefore incomes and losses are distributed according to the same criteria among all owners. Having one class of stock can prove to be an impediment when the business wants to obtain more capital. Partnerships, on the other hand, have some flexibility in the way profits and losses are distributed.
  • Contributions of Owners
    The partner's contributions of appreciated property to the business is tax-free for all partners, but similar contributions by S corporation shareholders to a corporation might be eligible for taxes in some circumstances.

Ownership Restrictions and Scalability

S corporations face strict limitations on who can own shares. Only U.S. citizens and resident aliens are permitted shareholders, and the total number of shareholders cannot exceed 100. These limitations can make S corps less ideal for businesses planning to raise capital through a wide range of investors or foreign ownership. In contrast, partnerships can have an unlimited number of partners from any residency or citizenship, allowing for greater scalability in certain international or investor-heavy ventures.

Partnerships also allow flexible entry and exit of partners with fewer legal hurdles. This flexibility makes them attractive for joint ventures and project-based collaborations.

Tax Treatment 

  • Borrowed Starting Capital
    S-Corp owners are not allowed to include borrowed funds as owners' basis. Partners, on the other hand, can include their borrowed share of the money as a basis. This is significant because small-business owners can deduct business losses arising from the business on their personal income tax returns. The deductions are limited to each owner's basis. Therefore, businesses that borrow money and operate at loss in the initial years are better off as partnerships because the owners are more likely to save on taxes.
  • Tax Types
    Owners of both entity types must pay personal income tax. Active partners, in addition, are required to pay self-employment taxes. This is not the case with S corporation owners. Employee shareholders do not pay self-employment taxes. Rather, employee shareholders must earn a salary from the business and pay FICA taxes. Dormant shareholders or partners do not pay any payroll taxes. 

Qualified Business Income (QBI) Deduction

Under the Tax Cuts and Jobs Act, both partnerships and S corps may qualify for the 20% Qualified Business Income (QBI) deduction. However, the calculation differs slightly between the two.

In partnerships, all business income is passed through to the partners, who may deduct 20% of their share of the qualified income. In an S corp, only the shareholder's portion of business income (after paying themselves a reasonable salary) is eligible for the deduction. Because S corp shareholders must receive a salary subject to payroll taxes, the QBI benefit may be somewhat reduced compared to partnerships. Still, the combination of salary and distributions may result in lower overall taxes when structured efficiently.

Formation and Maintenance 

  • Formation- Starting a partnership is relatively easy and generally does not require filing any paperwork with the state. A business that desires S-corp treatment, however, is required to first register either as a corporation or a limited liability company. The business must meet IRS requirements to file for S-corp treatment.
  • Maintenance Requirements-Businesses treated as S corporations must file annual or biennial reports with the state. If the business is a corporation, it must hold formal meetings. These requirements do not apply to partnerships.
  • Structure-Partnerships have minimal structural requirements. The basic requirement is that the partners have equal say even if their shares in the business are not equal. Partners can even agree on a profit and loss allocation method that is not based on their respective shares of the business. S-corps that are registered as corporations is required to have a formal management structure that includes a board of directors and officers. The only basis for allocating profits and loss in an S-corp is the number of shares the shareholder has.

Cost and Administrative Burden

Forming an S corp generally incurs higher startup and ongoing costs than a partnership. These include state filing fees, legal fees for incorporation, and additional accounting or legal assistance to comply with IRS rules for S corp election and maintenance. S corps must also adhere to corporate formalities such as holding annual meetings and keeping minutes, which can be time-consuming and complex.

Partnerships, on the other hand, require fewer formalities and lower administrative expenses. A simple partnership agreement can suffice for many businesses, and the lack of reporting obligations means ongoing maintenance is more straightforward.

Liability Protection

Owners of general partnerships are exposed to liability arising from debts incurred by the partnership. The personal assets of partners can be sold to cover debts from the partnership. This can be circumvented if the owners register as a limited partnership. In this case, all but one of the partners can have limited liability. All owners of an S-corp, on the other hand, have limited liability protection.

Risk Exposure and Insurance Considerations

While S corporations offer uniform limited liability protection to all shareholders, partners in a general partnership are personally liable for business debts and obligations, including actions taken by other partners. Limited partnerships offer some protection, but only to limited partners who do not participate in management.

As a result, general partners in a partnership may require higher levels of liability insurance to mitigate risk. In contrast, S corp shareholders are generally protected from claims beyond their investment in the business, barring fraud or personal guarantees. For businesses in high-risk industries, this distinction can be a deciding factor in the s corp vs partnership debate.

Frequently Asked Questions

1. Can I convert a partnership to an S corporation? Yes, you can convert a partnership into an S corp by forming a corporation or LLC and then filing IRS Form 2553 for S corp election. Legal and tax advice is recommended for this process.

2. Which is better for saving on taxes: S corp or partnership? It depends. S corps can offer savings through payroll tax advantages, while partnerships may offer more flexibility in deducting early losses and in applying the QBI deduction.

3. Can an S corp have foreign investors? No. S corps are restricted to U.S. citizens or resident aliens. This restriction does not apply to partnerships.

4. Which is easier to form and maintain? Partnerships are easier and cheaper to establish and manage. S corps require more formalities and have stricter compliance requirements.

5. Does an S corp offer better liability protection than a partnership? Yes. All shareholders in an S corp have limited liability, while only limited partners in a partnership enjoy similar protections. General partners remain personally liable.

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